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Christian Hviid
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An Investment strategist with multi-billion dollar portfolio management experience managing active Absolute and Relative oriented strategies in Unified Managed Account and Separate Account settings. Cross functional expertise covering asset allocation, risk management, manager and investment due... More
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Point Guard Capital LLC
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  • Pension Fantasy Returns 2 comments
    Apr 10, 2013 10:40 AM | about stocks: GE, MUR, NSC

    So this morning (4/10/2013) I read the Wall Street Journal, as I do each morning before the day starts, and found a very timely Opinion piece written by Andy Kessler: The Pension Rate-of-Return Fantasy. It just so happens that over the last several weeks I had been thinking deeply about this so-called pension assumption fantasy that exists in both the public and private pension plans. Municipal bankruptcy headlines and the delivery of company Annual Reports and Proxy Materials prompted me to conduct my own pension liability exercise.

    Just this week alone I received a few Annual Reports. Having been trained in accounting in addition to finance, I started reading from back-to-front focusing on the Notes to the Financial Statements. Any serious investor should at least skim these sections over to gain a better understanding of any company's operations and financials. Of the three that I received this week so far, I offer my own take on their pension return assumptions:

    CompanyInternal AssumptionMy AssumptionCurrent Funded Status
    Murphy Oil6.20%6.00%-$258 Million
    General Electric8.00%6.00%-$18.8 Billion
    Norfolk Southern8.25%6.00%-494 Million

    For illustration purposes only

    My assumptions for example in GE's mix of assets is as follows:

    US Equities - 7.00%

    International Equities - 8.00%

    Debt Securities - 3.00%

    Private Equity - a generous 12%

    Real Estate - 8.00%

    Other (Mainly of Hedge Funds) - 5.00%

    The bottom-line without boring you with the details and an "honorary certificate" in pension accounting is that when actuarial rate of return assumptions are higher than what they should be, pension obligations (read liabilities) can be understated and pension expenses reduced. The logic being that whatever the company does not contribute, the market performance will make up - yeah right! There is another issue with the discount rates being overstated given current low interest rates but I think the conclusion directionally is correct without digging too much further into that part of the actuarial assumptions made by pension committees. Why is this important? In GE's case for example a 0.50% reduction in return assumption would imply an increase of $200 Million in pension cost in the following year. If the discount rate was reduced by 0.25% pension costs would increase by $200 Million and Pension Benefit Obligations would rise by $2 Billion. If we were to reconcile theirs with my assumption GE would have an additional $800 Million pension cost expense and an increase in Pension Benefit Obligations.

    California Public Employees' Retirement System, or Calpers, has a 7.50%. The reality, as Mr. Kessler argues, is that the realized return in the future will likely be lower than expected. I could not agree more given my own calculations.

    J.P. Morgan's latest Guide to the Markets slide #66 illustrates that of the S&P 500 company pension plans, 94% are underfunded and the average return assumption is 7.3% as of 2011. Given today's expected rates of return for various asset classes, 7.3% seems quite high. Hence, both pension costs and liabilities are both being underestimated systemically.

    The time may have come where reality needs to set in for pension plans across the globe to carefully ask their consultants and themselves the tough question - are our assumptions realistic? Fiction and fantasy is fun in books, movies and playing with my 4-year old but in real life this kind of fantasy can only end up hurting people in the end one way or another.

    There are few ways to address the "pension cliff," just like any other deficit situation. One can either increase the contributions to fund the future liabilities while adjusting assumptions in a measured manner or benefits can be cut. Either way the expense of doing either is very dear and could have serious bottom-line implications over the medium to long term time horizon.

    Yet another reminder that we all have to be accountable for our own standard of living in retirement. Start planning appropriate steps to secure your financial well being in the future by setting an appropriate course for yourself and live within your means.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Additional disclosure: The information and opinions contained in this document have been compiled or arrived at from sources believed to be reliable, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. The views and opinions are the author's only and may or may not reflect the views of Point Guard Capital LLC. This document is for informational purposes only and is not, and should not be construed as, an offer or a commitment to enter into a transaction, nor is it professional advice. This information is general in nature only and does not take into account an individual’s personal circumstances. All opinions expressed in this document are subject to change without notice. The author does not accept any liability whatsoever for any loss howsoever arising from any use of this document or its contents or otherwise arising in connection therewith.

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Comments (2)
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  • RMIT
    , contributor
    Comment (1) | Send Message
    This was recommended by Bob Brinker some time ago on his Money Talk Radio Program. He suggested is for personal asset allocation. You take your fixed income receipts such as defined benefit pension, social security, etc. and total them for the month X 12 for the year. Then choose an interest rate, say 5%, and divided into this sum. This will give you the fixed income you would need to produce you fixed income total calculated above. He calls this your "Phantom Balance Sheet." This is used so you can increase your asset allocation to stocks for stock/fixed inc. allocations.
    11 Apr 2013, 08:55 AM Reply Like
  • Christian Hviid
    , contributor
    Comments (9) | Send Message
    Author’s reply » RMIT, to clarify, my assumption percentages above are expected rates of return over the medium-term for each class. If I follow your logic there is one very important danger in your (Brinker's) approach given the current low interest rate environment. A lower interest rate as a divisor will augment the "phantom fixed income" allocation you mention. The risk being that investors may draw a dangerous conclusion and allocate too much into riskier assets (read stocks). Rules of thumb are great but they assume "normal" environments. Given the Fed and other central bank "steroid" induced capital markets, we are not in a "normal" market environment. I would say that rules of thumb in this environment have to be carefully scrutinized. Thanks for your comment!
    12 Apr 2013, 11:02 AM Reply Like
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